Supreme Court adopts broad view of “actual fraud”

supreme-court-seal-opt-200pxIn a recent decision, the United States Supreme Court ruled that “fraudulent conveyance schemes” fall within the definition of “actual fraud” for non-dischargeability purposes under the Bankruptcy Code.  The Court overruled the Fifth Circuit which had held that a misrepresentation was a necessary element of “actual fraud.”  The Court held that “actual fraud” as it relates to bankruptcy discharges may be committed by purposeful concealment in addition to false misrepresentations.

Husky International Electronics, Inc. v. Ritz, involved a business owner, Daniel Lee Ritz, Jr. (“Ritz”), who transferred assets from a company he directed, Chrysalis Manufacturing Corp. (“Chrysalis”), to other entities in which he owned substantial equity.  Prior to the transfers, Husky had sold equipment to Chrysalis and was owed unsecured debt by Chrysalis.

When Husky sued Ritz personally for the debt under a state law fraud theory, Ritz filed for chapter 7 bankruptcy relief.  Husky then sought to have the Chrysalis debt declared non-dischargeable as to Ritz under section 523(a)(2)(A) of the Bankruptcy Code.  That section prevents debtors from discharging debts “obtained by false pretenses, a false representation, or actual fraud.”  Husky argued that Ritz engaged in “actual fraud” when he transferred assets from Chrysalis to other entities he controlled in an apparent fraudulent conveyance scheme.

The Court held that a fraudulent conveyance scheme constitutes “actual fraud” but did not explicitly rule that the Husky debt was “obtained by” fraud.  The Court hinted that if the transferor and transferee were in some meaningful way the same, the debt may be deemed to be “obtained by” fraud.  The Court noted that the phrase “obtained by . . . actual fraud” does not require that the debt result from fraud that took place at the inception of the credit transaction.  The Court also noted that the creditor need not prove that he “relied” on a fraudulent misrepresentation or omission when granting credit.

A dissent criticized the majority opinion arguing among other factors that the Husky debt was not “obtained” by fraud, both because the debt did not originate between Ritz and Husky, but also because any fraudulent conveyance by Ritz did not create the Chrysalis debt.

While the Court’s decision was a narrow interpretation of the phrase “obtained by . . . actual fraud,” it opens the door for creditors to make non-dischargeability claims against corporate insiders who engage in fraudulent transfer schemes, provided the creditor can prove that the corporate insider is otherwise personally liable for the corporation’s debt.